What Is Economic Deflation?

Definition and Examples of Economic Deflation

"Deflation" is an economic term that describes an environment of declining prices for goods and services within an economy. Not to be confused with disinflation, or a decrease in the rate of inflation, deflation occurs when the rate of inflation is less than 0%.

• Alternate name: Negative inflation

The Consumer Price Index (CPI) is the most commonly used measure of inflation. CPI measures the prices of household goods and services in the economy. If CPI goes into a negative number, that's deflation.

The United States has experienced several periods of deflation. For example, deflation occurred in 2009 due to the Financial Crisis and the Great Recession in which the Consumer Price Index was -0.04%. During the Great Depression, U.S. deflation was much more severe and occurred over multiple years as shown below:

• 1930: -2.7%
• 1931: -8.9%
• 1932: -10.3%
• 1933: -5.2%

How Economic Deflation Works

Understanding the economics of deflation can make you a better investor. Typically, deflation has occurred during recessions, where demand for most goods and services declines and the providers of these goods and services lower prices to compete for fewer consumer dollars.

In extreme cases, consumers delay purchases in anticipation of further price declines. This can often lead to a self-fulfilling prophecy of lower prices, where consumers expect lower prices and create them by forgoing purchases.

Deflation might sound like a good thing for consumers, but lower prices are a reflection of lower demand, which arises because lower demand leads to lower revenues, leading to layoffs and less income for consumers. 

Deflation can also be caused for positive reasons—through increased productivity, advances in technology, and new sources of resources or innovation. In this sense, it can be good for an economy because it gives consumers more buying power. The issue is how quickly it occurs.

Tips for Investing in an Economic Deflation

Investing during economic deflation can be challenging—asset prices are falling, causing a loss of interest and value in cash, gold, real estate, and stocks. While these assets generally pay off in an inflationary environment, during a deflationary period they tend to create losses.

Certain sector funds that invest in defensive areas, such as healthcare, utilities, staple items, and certain commodities—things people need regardless of economic conditions—can also be good investments during deflationary periods. For example, people still need to go to the doctor, use electricity, and brush their teeth when the economy and stock market are on the decline. This demand generally prevents stocks in those sectors from declining as much as in the broader market.

The Federal Reserve exercises monetary policy that works to prevent a deflationary spiral and tries to keep the period from lasting for an extended period of time. Therefore, investments that do well when interest rates are falling can do well during periods of deflation.

There is a risky market-timing element when trying to choose the best investments during an expected short-term deflationary environment. Trying to navigate the market and economic conditions with investment strategies is a form of market timing that carries a significant risk of losing value in an investment account. For most investors, building a diversified portfolio of mutual funds is the best strategy for all market and economic environments.